The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Thursday, June 13, 2013

Small problem with Fed policies, it is real wages, not wealth effect, that drive US consumer spending

As Pedro da Costa reports in his Reuters blog, a survey shows that it is real wages and not the wealth effect that drive US consumer spending.

This is important because the Fed's monetary policy, including zero interest rates and quantitative easing, is reliant on the wealth effect to drive growth in demand.

Did this reliance ever make sense in anything other than an economic model?

No.

There is no reason to believe that the wealthy dramatically increase or decrease their spending because of the level of interest rates rather than base their spending on what they earn as income each year.

If your humble blogger had to guess why economists believe in the wealth effect it is that they confuse correlation with causation.

Specifically, they saw consumption pick up over the last 30 years as both stock and house prices increased and said "aha, there must be a wealth effect as an increase in wealth is correlated with higher consumption".

In reality, what was really happening is that Wall Street became quite proficient at letting Main Street tap the equity in their houses and Main Street needed to tap this equity because growth in income was insufficient to support the lifestyle they had from previous years.

Federal Reserve officials have touted the ‘wealth effect’ from higher stock prices and rising home values as a key way in which monetary policy boosts consumer spending and economic activity.

But according to the results of a recent survey from the Royal Bank of Canada, that ethereal feeling of being richer on paper is no substitute for cold, hard cash.

The tools we have involve affecting financial asset prices and those are the tools of monetary policy. There are a number of different channels – mortgage rates, I mentioned corporate bond rates, but also prices of various assets, like for example the prices of homes.

To the extent that home prices begin to rise, consumers will feel wealthier, they’ll feel more disposed to spend. If house prices are rising people may be more willing to buy homes because they think that they will make a better return on that purchase. So house prices is one vehicle....

The issue here is whether or not improving asset prices generally will make people more willing to spend.

One of the main concerns that firms have is there is not enough demand, there’s not enough people coming and demanding their products. If people feel that their financial situation is better because their 401(k) looks better for whatever reason, or their house is worth more, they are more willing to go out and provide the demand.....

RBC survey’s findings, explained by the bank’s chief U.S. economist, Tom Porcelli, in a research note:

That wages and the jobs backdrop matter for consumption is not only borne out in the hard data, but this also came through loud and clear in our June consumer survey.

When asked about what would embolden them to increase spending, nearly half of respondents noted wage increases while about 1/5 said a better job backdrop. So 65% of consumers think employment dynamics are what matter most. Contrary to popular belief, there was little “wealth effect” from stocks and housing apparent here.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.